Dr Ethics: Three Defenses That Your Broker May Use When You Sue and Three Offenses to Address Them

The adage that “the best defense is a good offense” is particularly relevant for individual investors who must arbitrate their disputes with brokers and brokerage firms at FINRA (the Financial Industry Regulatory Authority). A recent New York Times article focused on two individual investors who were awarded $54.1 million in an arbitration case against Citigroup.

What piqued my interest was the discussion of three defenses that brokerage firms commonly use when clients sue and how these defenses were ineffective in this case. The purpose of this article is to make you aware of these defenses, offer suggestions for combating these defenses, and provide you with questions to ask your adviser/broker that will hopefully minimize the chances of having to turn to arbitration to resolve a dispute.

Offense:When presented with an investment product or idea, ask your adviser about its performance history in both up and down markets. If it is a new product, be especially wary because no one knows how it will perform under various market conditions.

In the Citigroup case, the clients invested in leveraged municipal bond investments. These products were brand new and had no track record. Unfortunately, they virtually imploded during the financial crisis, not because of the underlying municipal bonds (which did not suffer large losses) but because of the huge amount of leverage that was used to generate additional income.

Defense 2: “You are a sophisticated investor and therefore should have understood the risks.”

Offense: The SEC defines “accredited investors” as those have a net worth of $1 million (excluding their homes) or who have income exceeding $200,000 for the past two years are especially vulnerable to this defense. Although the definition of a sophisticated investor is less restrictive, both equate an investor’s financial position with their financial acumen. By virtue of their net worth or income, an accredited or a sophisticated investor is assumed to have: 1) the investment experience and knowledge to evaluate the risks and benefits of an investment; 2) the ability to hold investments indefinitely; and 3) the financial wherewithal to sustain a total loss of investment principal. As a result, sophisticated/accredited investors are often exempt from some of the protections that are provided to other investors.

Therefore, if you fit the definition of a sophisticated/accredited investor but don’t have the “assumed” investment experience or knowledge, then you must make this very clear to your adviser. In addition, you must ask questions until you are comfortable with the investment recommendation that is being made. As I always tell people: “If you don’t understand it, don’t invest in it.”

Although both investors in the Citigroup case were considered accredited or sophisticated and thus able to understand and tolerate risks, at least in the eyes of regulators, they had made it clear to their broker that they did not want to add risk with the Citigroup products they invested in.

Defense 3: “You were given the prospectus, which described all of the features of the investment and warned you about the risks. So don’t blame us if you didn’t read it.”

Offense: Face it, you must read the prospectus. It is the legal document that is designed to disclose all of the important characteristics and risks of an investment. Yes, reading the prospectus can be as dull as watching paint dry, but the SEC has made an effort to reduce the amount of “legalese” it contains by requiring that the cover page, summary, and risk factors sections of the prospectus be written in plain English. In other words, these sections should be written in an active voice and exclude highly technical business and legal and terms. Pay particular attention to the risk factors section, which lists and briefly explains the risks of the product or security. Ask yourself whether these risk factors are acceptable. For example, could you stand to lose your entire investment?

The “prospectus defense” is one of the most commonly used and effective defenses because it is evidence that investors were aware of all the important facts and risk. In addition to reading the prospectus, you should compare the prospectus with the firm’s sales/marketing brochure about the investment to determine whether the information in both is consistent. If not, ask your broker to explain any inconsistencies.

In the Citigroup case, the disclosures in the company’s sales brochure about the risks of the product were not as complete as in the prospectus.

There are a number of websites as well as videos that are helpful for deciphering the information in a prospectus. Below are a few independent groups who have released helpful information:

The bottom line for investors: Determine whether a particular investment or strategy is suitable based on your investment objectives, risk tolerance, time horizon, and other factors. Although making this determination is part of your adviser’s responsibility, it is your money, so you also need to make your own determination of suitability. Below is a list of questions to ask your adviser the next time he or she presents an investment idea, product, or strategy to you. If you are not given complete and satisfactory answers to these questions, then perhaps the investment or your adviser is not suitable for you.

What are the product’s investment objectives?

How does this product add to, improve, or diversify your current portfolio?

Are there less costly, less complex, or less risky products that can achieve the same objectives?

What are the key assumptions that underlie the product? What market or performance factors will be used to determine the product’s return?

What costs and fees are associated with the product? How is your investment adviser compensated for offering this product? What compensation will the investment adviser receive for the sale of this product?

Does the product have any unusual risks, such as legal, tax, market, or credit risks?

How liquid (i.e., easy to sell) is the product? Is there a secondary market for it?

Who would this product not be suitable for? Sometimes, it can be easier to determine a product’s suitability by finding out who it would not be suitable for.

The information contained in this article and from any related communication is for informational and educational purposes only. The information in this article should not be interpreted or used as investment advice. CFA Institute does not recommend or endorse any investment security, product, or strategy or any service, product or material submitted by or linked to this article by third parties.

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